INTRODUCTION TO MUTUAL FUNDS
“Mutual funds are subject to market risks, read all scheme related documents carefully. “
Now, this is something I can bet each one of us would have heard at least once And another thing which would have definitely come to our minds after listening or reading this would be, what are mutual funds? This makes me bet on another part that how most of us would have let that question just go by. As clear from the title, in this article I will give you a basic structure of mutual funds ( for all those who didn’t actually let that question go by 😉) answering some simple questions like what actually are mutual funds, how do we invest in them, their advantages their disadvantages etc.
What are Mutual Funds?
Starting with the answer to the very basic question of this article-
A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Basically, Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.
A further simplification to this is that mutual funds pool money from the investing public and use that money to buy other securities, which are usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So for example, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or stating more precisely, a part of the portfolio’s value.
Overall these funds offer a way for a group of investors to effectively pool their money so they can invest in a wider variety of investment vehicles and take advantage of professional money management through the purchase of one mutual fund share. Effectively, When you buy a mutual fund share, you’re investing in stocks, bonds and other securities that are held within the fund.
How do Mutual Funds Work?
Now let’s understand the next basic concept i.e their working.
Mutual funds have a dual nature i.e they are both an investment and an actual company. This nature may seem strange but it will be cleared from the following example- When an investor buys Apple stock, he is buying part ownership of the company and its assets. Similarly, a mutual fund investor is buying part ownership of the mutual fund company and its assets. The difference is that Apple is in the business of making smartphones and tablets, while a mutual fund company is in the business of making investments.
Now considering that a mutual fund is a virtual company, means its CEO is the fund manager, sometimes also called its investment adviser who is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. And most of the fund managers are also owners of the fund.
A Mutual Fund Company has very few other employees. The fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund’s NAV ( the price of a mutual fund share which is also known as the net asset value per share. It is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding) that determines if share prices go up or down. Mutual funds also need to have a compliance officer or two, and probably an attorney, to keep up with government regulations.
Most of the mutual funds out there are a part of a much larger investment company; the biggest of which have hundreds of separate mutual funds. Many of us will be familiar to some of these fund companies such as Fidelity Investments, the Vanguard Group, T. Rowe Price, and Oppenheimer Funds.
Types of Mutual Funds:
After getting the idea of what are mutual funds and how do they work, let’s get into the type of mutual funds present.
There are 4 types of mutual funds:-
1) Equity Funds :
The largest category is that of equity or stock funds. As the name implies, this sort of fund invests principally in stocks. Within this group are various sub-categories. Some equity funds are named for the size of the companies they invest in like small-, mid- or large-cap while the others are named by their investment approach: aggressive growth, income-oriented, value, and others. They are also categorized by whether they invest in domestic stocks or foreign equities.
2) Fixed-Income Funds
The next is the fixed income category. A fixed income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The principle idea is that the fund portfolio generates interest income, which then passes on to the shareholders.
3) Index Funds
It has become extremely popular in the last few years only. Their investment strategy is based on the belief that it is very hard, and often expensive, to try to beat the market consistently. It is said to provide broad market exposure, low operating expenses and low portfolio turnover. These funds follow their benchmark index no matter the state of the markets. Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs). Legendary investor Warren Buffett has recommended index funds as a “haven for savings for the sunset years of life”.
4) Balanced Funds
These funds invest in both stocks and bonds to reduce the risk of exposure to one asset class or another. Another name for this type of mutual fund is “asset allocation fund.” This fund’s goal is asset appreciation with lower risk. However, these funds carry the same risk to fluctuation as other classifications of funds.
Therefore summarizing the different types we conclude that there is a fund for nearly every type of investor or an investment approach. Other common types of mutual funds include money market funds, sector funds, alternative funds, smart-beta funds, target-date funds, and even funds-of-funds, or mutual funds that buy shares of other mutual funds.
Why Mutual Funds?
Now, many of you will be wondering that though we are getting to learn about mutual funds, why we should choose them when we have other options, which brings me to the next topic of my article i.e Advantages of Mutual funds.
1) Diversification
Also known as the mixing of investments and assets within a portfolio to reduce risk, is one of the biggest advantages of investing in mutual funds. Buying individual company stocks and offsetting them with industrial sector stocks, for example, offers some diversification. Buying a mutual fund can achieve diversification cheaper and faster than by buying individual securities.
2) Easy Access
While trading mutual funds can be both bought and sold with relative ease, making them highly liquid investments. Also, when it comes to certain types of assets, like foreign equities these funds are often the most feasible way or in fact sometimes the only way for individual investors to participate.
3) Economies of Scale
It’s very important to know that buying only one security at a time leads to large transaction fees which eat up a good chunk of the investment. Also many a time an individual investor might not always be able to afford to buy a lot of the stock, but with the same money, it may help him/her purchase many mutual fund shares. In this way smaller denominations of mutual funds allow investors to take advantage of dollar cost averaging.
4) Freedom of Choice
This means that the investors have the freedom to research and select from managers with a variety of styles and management goals. For instance, a fund manager may focus on value investing, growth investing, developed markets, emerging markets, income or macroeconomic investing, among many other styles.
Disadvantages of Mutual funds
A very common thing which everyone knows is that everything has its own advantages and disadvantages. Since we have talked about the advantages let’s also have a look at the other side of mutual funds.
1) Fluctuating Returns
Of course, almost every investment carries risk and so there is always the possibility that the value of your mutual fund will depreciate. Equity mutual funds experience price fluctuations, along with the stocks that make up the fund. The Federal Deposit Insurance Corporation (FDIC) does not back up mutual fund investments, and there is no guarantee of performance with any fund, unlike their bank counterparts.
2) Heavy Cash Supplies
From their definition, we know that mutual funds pool money from thousands of investors, so this means that every day people are putting money into the fund as well as withdrawing from it. And to maintain the capacity to accommodate withdrawals, funds typically have to keep a large portion of their portfolios in cash. Having ample cash is excellent for liquidity, but money sitting around as cash and not working for you thus makes it not very advantageous.
3) Lack of Transparency
A fund’s purpose or makeup isn’t always clear. Fund advertisements can guide investors down the wrong path. The Securities and Exchange Commission (SEC) requires that funds have at least 80% of assets in the particular type of investment implied in their names. But how the remaining assets are invested is up to the fund manager. Also, the different categories that qualify for the required 80% of the assets might be vague and wide-ranging leading to lack of transparency.
4) Evaluating Funds
Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose the price to earnings (P/E) ratio, sales growth, earnings per share (EPS), or other important data. A mutual fund’s net asset value can offer some basis for comparison, but given the diversity of portfolios, the job becomes difficult. Only index funds tracking the same markets tend to be genuinely comparable.
Conclusion
After reading this article one thing that becomes very clear is that understanding about mutual funds is a very vast topic and obviously everything can’t be explained in this article. The sole purpose of this article was to make all of you get a brief idea about mutual funds and therefore those who are highly interested in learning more about them should definitely make the efforts. Hope you had good learning!
